Monetary policy at the edge of QE

The world of economic policy, monetary and fiscal, is the realm of fooling ourselves into believing that, when everything else fails, there is a saviour of last resort, a sort of higher power available to those willing to deploy it for common good. This power, per textbooks on economics, can break recessions, bend deflationary dynamics, and will the laws of social evolution. It is a powerful illusion, capturing the minds of policymakers (from the US President and a score of the 2020 presidential hopefuls, to cohorts of European apparatchiks and parliamentarians), of markets analysts and investors (from hedge funders to cut-throat vulture funds managers), and of academic economists (including those advocating Washington’s flavour-of-the-day Modern Monetary Theory).

This belief is currently at play across the advanced economies, gripped by the long-run crisis of twin secular stagnation: anaemic growth on both the demand and supply sides of private consumption, investment and productivity.

Driven by adverse demographics, falling real impact of technological progress and decades of manipulation of the markets to the will of central planners, the secular stagnation is a structural phenomenon. As such, it renders traditional policy tools, such as increased government spending and money printing, powerless, challenging the very notion of an economic panacea of last resort.

Look no further than the current path of the monetary policy in the advanced economies. At the peak of Quantitative Easing (QE) in the second quarter of 2018, the US Federal Reserve, the European Central Bank and the Bank of Japan, collectively held just below US$15 trillion worth of assets. One year later, after months of synchronised ‘tightening’ by the central banks, cumulative assets held by the same big three monetary authorities are at $14.2 trillion, a drop of just 5% on the peak. In other words, for all the buzz in the markets and the media about quantitative tightening (QT), the central bankers have managed to unwind only five months-worth of QE over the period of twelve months of QT. During the same period, the unweighted average of the key policy rates set by the big three has moved only 25 basis points, from 0.51% in March 2018 to 0.76% a year later.

Put differently, anyone believing that the central bankers’ new monetary ‘normal’ does not involve endless support for low interest rates and virtually unlimited banking and financial markets liquidity is doing exactly what Richard Feynman warned us not to do: fool ourselves.

The news flow from the Western front of battling for monetary normality is also telling us not to buy into the powers of the printing press. In recent months, the Fed effectively paused interest rates hikes, and the markets are now pricing a substantial likelihood of a 25 basis points rate cut for 2019. Just two months ago, the consensus was for a 50 bps hike over the same time, providing for the monetary conditions easing of 75 basis points over the duration of this year alone. The most recent additions to the Fed Governing Board are signalling the end of the fragile attempts at brining the cost of capital in line with historical norms. These changes in the Fed policy positioning are reflected in ever-accelerating calls from financial markets for the Fed to re-engage in a QE 5 programme, with some analysts going as far as suggesting that this time around, the Fed should be buying not only US government bonds, but also corporate bonds and equities.

The same dynamics are evident in the calls for ECB to continue pausing interest rates hikes beyond December 2019. Most recent poll by Reuters found that 51% of Wall Street economists are expecting the first hikes in ECB rates by the end of the third quarter 2020, while 45% expect no rate rises through 2020. Markets analysts are currently expecting the ECB refinancing rate to remain at zero through 2020, against the consensus expectation of at least one rate hike in 2020 just a month ago. For the first time since 2016, analysts’ consensus has shifted toward an expectation that Frankfurt will re-engage its printing press.

More than that, the ECB is also considering a new twist on the already expansionary monetary policy. Per recent reports, the ECB is studying the option of creating a tiered deposit rate system in order to recycle back into the financial system some EUR7 billion in annual interest charges it collects from bank deposits.

The problem with the latest developments is that more than a decade-long experiment with the monetary easing on an unprecedented scale has left the advanced economies in exactly the same predicament as they were at the tail end of the global financial crisis. While economic growth uncertainty remains high, official inflation is running well below central banks’ policy targets, and real productive non-financial investment tracking well below its past historical levels. In other words, monetary policy has not worked, is not working, and is not about to start working.

At the end of 2018, the Fed’s combined holdings of government and private securities amounted to 19.6% of the US GDP, ECB’s balance sheet was at 39.8% of the euro area GDP, and Bank of Japan’s holdings were at 100.6% of the country annual output. Virtually all of this money went to fund government spending and investment, and to beef up the valuations of financial assets. The result is a blowout in private and public and private debt, plus a massive bubble in financial markets.

Meanwhile, US total productivity in the non-farm private sector expanded at an average annual rate of 1.3% over the period of QE, less than half the rate of growth from 2000 to 2007, and 0.9 percentage points below the 1990 to 2000 average, based on the data from the Bureau of Labor Statistics. In the euro area, annual labour productivity growth averaged over 1.14 % over the 1990s, falling to 0.97% in the period 2000 to 2007 and to 0.41% during the QE period, based on ECB data. Productivity growth in terms of GDP per hour worked has followed exactly the same trends, as Chart 1 illustrates.

Despite low unemployment (in part due to collapsed labour force participation rates post-global financial crisis, and lower wage jobs creation in the services sectors over 2010-2016), and booming financial markets, consensus forecasts now indicate high (and rising) probability of a US recession by the end of 2020, and a growing view that a Eurozone recession is becoming increasingly likely in late 2019 or early 2020. Euro area leading growth indicators (from eurocoin to purchasing managers indices) are currently showing significant slowdown in core economic activity across the common currency’s largest economies. Inflation remains stubbornly anchored at around 1%. Thus, in a recent note, Fitch Ratings projected that the ECB will restart asset purchases at the end of 2019.

Investment contribution to GDP growth has virtually collapsed. In the 1990s, net of M&As and shares buybacks, it averaged over 0.68% annually across the advanced economies, based on the data from IMF and Factset. In the 2000s, average contribution from investment to GDP was running at over 0.67 percent. Since the start of the global QE programmes, the same figure through the third quarter of 2018 was below 0.349%. Chart 2 shows the trend.

As illustrated in Chart 3, over the same time horizon, relative price of capital goods – a measure of tangible investment costs – has fallen almost 55%. In simple terms, therefore, cheaper capital is yielding less investment – a scenario that can only be accounted for by the non-financial (and non-monetary) drivers for slower growth and, thus, lower investment opportunities, and lower investment demand.

The truth is: no matter how much we wish for the reality to be different, the idea that monetary policies of the past can be made to work in the age of structurally slower growth is an illusion, a myth we perpetuate for the lack of any alternatives. Come the next crisis, the central banks will not only be out of the proverbial bullets, but their guns will be about as effective as a water pistol at a pub fight.

At the edge of the QE decade, we are left with two lessons worth learning.

The first one is that in the age of the demand- and supply-side secular stagnation, monetary policy, no matter how expansionary (Bank of Japan) or inventive (ECB) or timely (the Fed) holds no promise of a structural recovery. This, in turn, implies that the economy’s leveraging capacity, the effectiveness of debt as a driver for growth, is now smaller than in the past.

Future growth, therefore, will have to come from drivers other than demographics, debt and fiscal or monetary spending. In other words, to continue thriving, the West must return technological and labour productivity growth rates to pre-crisis levels.

The second one is that dealing with secular stagnations will require a painful restructuring of the entire economy. The West needs large scale private investment in productivity growth, not a monetary stimulus-induced M&A and shares buybacks binge. These investments have to be organic – originating from the market participants, and not from the state-sponsored investment funds. This means we need aggressive deployment of new incentives for entrepreneurship and real investment: reduced tax burden on early stage finance, capital gains from equity investments, elimination of asymmetric incentives for debt financing over equity and improved incentives for employee share ownership (as opposed to executive compensation). In addition, it requires improved incentives for human capital investments, such as restructuring of the student loans to reduce the level of financial burden arising at the early stages of professional careers, and full tax deductibility of professional and STEM (Science, Technology, Engineering and Maths) degrees tuition.

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